As the mortgage industry girds for life under the Dodd-Frank Act, two legislated products are capturing bankers' attention.
The one getting the most eyeballs is the qualified residential mortgage (QRM), which challenges a lender to meet certain underwriting standards or, failing that, to retain 5% of the credit risk should the loan in question be securitized and sold to an entity other than Fannie Mae or Freddie Mac.
QRM's sister product, the qualified mortgage (QM), also penalizes lenders when its conditions are unmet for all residential first-lien loans. Under QM, the penalties are legal — and the ramifications for a violation may be wider.
The new rules are intended to prevent lenders from making the types of exotic loans that have been blamed for setting off the mortgage meltdown.
All well and good, but as proposed, the rules would drive up the cost of credit for many low- and moderate-income borrowers, while shutting out many others, said both mortgage bankers and their lawyers, now studying the fine print.
"I think that the natural consequence of QM and QRM is that only the most privileged borrowers in our country will be able to get mortgage loans unless the regulations are changed," said Laurence Platt, a partner at the Washington law firm K&L Gates, "because they won't meet the standards."
Six different agencies have to sign off on the rule that is the basis for QRM.
In contrast, the Federal Reserve Board alone handles QM, which comes out of Dodd-Frank enhancements to the Truth in Lending Act's Regulation Z: the ability-to-repay provision. The Fed is soliciting public comment on it until July 21, after which responsibility for final rulemaking passes to the Consumer Financial Protection Bureau.
One comment the Fed may hear: there is too much overlap between the rules and that they need to be simplified. "We are still trying to sort it all out," said Stephen O'Connor, senior vice president for public policy and industry relations at the Mortgage Bankers Association (MBA). "We think that they [the new rules] should be synchronized and similar as possible."
"If you are going to go in the direction of making a good QM standard, then the question becomes whether you should make the QRM closer to the QM," said Kenneth Markison, associate vice-president and regulatory counsel for public policy and industry relations at the MBA. "Because maybe that is all you need."
The legal penalties for violating TILA's enhanced ability-to-repay provision can be severe; if made outside QM's proposed safe harbor, the loan's owner could run into a raft of legal counterclaims if it tries to foreclose on a borrower in default. In addition, lenders could get fined a million dollars a day for knowingly originating a loan violating the enhanced Regulation Z.
Under QRM, for loans to meet standards, the borrower has to make a minimum down payment of 20% and they have to have a relatively low debt-to-income ratio. According to the Federal Deposit Insurance Corp., approximately $8.5 trillion in outstanding mortgages would not have qualified as QRM loans if they were made under the proposed risk-retention rule. Under the rule, lenders may make non-QRM mortgages, but they will have to keep 5% of the credit risk of any asset that is transferred, sold or conveyed to a third party. And lenders said that the 5% risk-retention stipulation for non-QRM mortgages will add to the cost of making the loan, and they maintain that this expense will be passed along to the consumer.
Lenders also can make exotic loans that don't conform to the QM standard. However, to do so requires more extensive underwriting: they must consider and verify eight underwriting factors, including the borrower's current debt obligations, monthly debt-to-income ratio and credit history.
"The way that Dodd-Frank works is that the consumer in foreclosure can assert a failure of the ability-to-repay standard, no matter how many years later, and that claim can result in an offsetting financial claim of the finance charges, payments of interest the consumer has paid — so in effect, you have a big counterclaim," Markison said.
However, consumer advocates said that the enhanced ability-to-repay provision will protect consumers and force banks to do better underwriting. "The remedy is really the guarantee that lenders won't do collateral-based lending, which is one of the hallmarks of predatory lending," said Diane Thompson, a lawyer at the National Consumer Law Center. "So if they don't comply with the rules, fine. But they won't be able to take the house, so that really is going to force them to do the underwriting."
Given the potential liabilities, many lenders will undoubtedly choose to make QM loans that provide special protections, such as a potential safe harbor, from liability for violations of the TILA ability-to-repay provision. QM loans will primarily be plain vanilla, although a special balloon payment QM mortgage is allowed in rural or underserved areas.
In general, "to meet the QM standard, you cannot have the neg-am interest only or balloon payment or a loan payment term exceeding 30 years," Markison said. "You take on the legal risk under QM, and you take on the risk retention under QRM, because those products are also ineligible for the exemption under QRM — so there is more risk all around — you can still make the loan, but you will charge a premium for all of that additional risk, which means it will be more expensive for the borrower."
Some consumer advocates call banks' concerns about QM-related litigation overblown.
"The fact is, the litigation has never been as great as they like to say it has, and it probably won't be in the future, for the simple fact that most people in foreclosure cannot find access to lawyers who know what they are doing," said Kathleen Keest, senior policy counsel at the Center for Responsible Lending."
"People don't sue banks willy-nilly; they only tend to raise these things defensively or when they are close to foreclosure, so if you get hit with a lot of these lawsuits, it is probably because you didn't address the ability-to-repay standard," Keest said.
However, the proposed rules also create potential legal risks for lenders, according to Platt. "The natural consequence of these rules will be a disproportionate adverse impact on minorities' being able to get loans," Platt said.
"So that in and of itself will raise fair-housing issues, and then if what lenders do is increase the price on nonqualifying loans to account for the risk and minorities get those loans in greater numbers, then they are paying higher amounts. So it is either denial of credit or higher prices, but either way, it will lead to fair-lending claims."
One significant distinction between the two types of rules is that QRM applies primarily to mortgage originators, while QM expands assignee liability so that in addition to lenders, securitizers and investors also can be held liable for violations of TILA's ability-to-repay provision.
Some investors and lenders may still have an appetite for buying and selling exotic loans, even with the increased risk. "It will be a great opportunity for lenders who can deal with the non-QM stuff," said Paul Schieber, a partner at Stevens & Lee in Philadelphia. "There will be a niche for someone who is willing to take on the risk, but it will be driven by how much the investment community can tolerate it."
Although the mortgage banking industry is chafing at both the proposed rules, consumer advocates are primarily worried about QRM.
"I have concerns about QRM because I don't think that the down-payment restriction of 20% is reasonably related to the actual riskiness of the loan, and it will unequivocally bar folks that don't have a lot of wealth from homeownership," Thompson said. "But from what I have seen of the QM rule, I think that it is generally in the right direction — you want to figure how to get people access to credit, but you want to make sure that it is credit that is not going to destroy their lives."
One potentially huge loophole for lenders in QM is that it only applies to closed-end loans and not home equity lines of credit. "What it means is that the abuses are going to migrate to open-end credit to the extent they haven't already," Thompson said. "I hear stories of clients who need a $10,000 loan, and they are steered to a HELOC because they are told that the banks want to do it that way. And the reason that banks want to do it that way is that there are fewer disclosures on HELOCs, and therefore fewer protections."
In general, however, Thompson said that QM will be much more of a brake on lenders making bad loans than QRM.
"The QM rule is going to apply to a much broader section of the market," she said, whereas "the big thing about the QRM rule is the risk-retention rule. However, many of the subprime securitizers such as New Century routinely retained 5% of their loans or interest in the total pool, so it is not clear the retention is going to be very meaningful by itself."
Schieber said the QM rule unfairly restricts the options of wealthier borrowers. "A negative amortization loan may be totally appropriate for someone with substantial assets," he said. "My personal view is that if you have a sophisticated borrower who has real assets, like a hedge fund investor with an estate on the south shore of Connecticut, why expose them to these kinds of restrictions?"
Ultimately all consumers stand to lose from QM, Schieber said. "The only thing I have to say in favor of QM is that it adds certainty — there is a pretty low common denominator. Is that good for the industry? No. Is it good for the public in general? No. Is it pretty straightforward? I think that the answer is going to be yes, but I don't think that is ultimately a good result."